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An infographic comparing three valuation methods - sales, income and asset based approach

Comparing Valuation Methods – Sales vs Income vs Cost

When valuing any business, there are three main approaches to determine the fair market value – the sales comparison approach, the income approach, and the asset-based (cost) approach. Each method has its own advantages and disadvantages. The method or combination of methods used depends on the type of business, the purpose of the valuation, and data availability.

Sales Comparison Approach

The sales comparison method, also known as market approach, is based on the economic principle of competition. It uses recent sales of similar businesses to estimate the value of the business being valued.

This valuation method is best suited for businesses that have many comparables. The value is derived by analysing the price at which other similar businesses in the industry have sold for. Adjustments may be made to account for differences between the comparables and subject business.

  • Advantages:
  • Relies on actual sales data rather than forecasts and assumptions
  • Easy to understand
  • Works well for homogenous business types like restaurants, retail stores etc. that have many comparables
  • Disadvantages:
  • Suitable comparables may not be available
  • Adjustments made to comparables may be subjective

Key factors:

  • Competition
  • Recent transactions
  • Similarities
  • Adjustments

Income Approach

The income approach values the business based on its income generating potential. The value is determined by either capitalising or discounting the expected economic benefits.

This method is commonly used for stable businesses with steady cash flows like medical practices, law firms etc. Key valuation methods under this approach include discounted cash flow (DCF) analysis and capitalised earnings.

  • Advantages:
  • Considers the business’ future income potential
  • Can value unique businesses with no comparables
  • Disadvantages:
  • Projections of future income may not be accurate
  • Determining the capitalization rate or discount rate is subjective

Key factors:

  • Future earnings
  • Capitalization rates
  • Discount rates

Asset-Based (Cost) Approach

The asset-based approach sums up the fair market value of all tangible and intangible assets and liabilities of the business. The value of the assets and liabilities are adjusted to current market values.

This method is suitable for asset-heavy businesses like real estate, manufacturing, and new businesses with few tangible assets. Value is derived by estimating replacement cost of assets and subtracting liabilities.

  • Advantages:
  • Simple and straightforward
  • Uses real assets that can be independently valued
  • Disadvantages:
  • Does not account for earning capacity of the business
  • Book values may not reflect current market value of assets

There is no one-size-fits-all approach to business valuation. Using a combination of valuation methods often provides the most reasonable estimate of value. The sales approach offers simplicity, the income method evaluates earning capacity, while the asset method considers the underlying assets. A skilled business appraiser carefully considers the merits of each approach and selects the most suitable method or hybrid method based on the business specifics.

Key Takeaways

  • The sales comparison approach estimates value based on recent sales of similar businesses. It relies on the principle of competition and works best when sufficient comparables exist.
  • The income approach values a business based on its income generating potential using methods like DCF analysis and capitalised earnings. It works well for businesses with steady cash flows.
  • The asset-based approach sums up the market value of all tangible and intangible assets and deducts liabilities. It focuses on the underlying real assets of a business.
  • There is no single best approach. Business valuers often use a combination of methods to arrive at a reasonable market value estimate. The approach depends on the business type, purpose, and data available.
  • Valuing a business is both an art and science. Market realities, qualitative factors, and appraiser judgement also influence the valuation along with quantitative methods.